Week 7-9 Rationality Summary

The standard definition of economic rationality

  • being rational means choosing appropriate (the best) actions (among those that are possible) in view of objectives

  • It is an instrumental view of rationality: choosing means in view of ends

• Rationality and self-interest (Edgeworth)

  • “the first principle of Economics is that every agent is actuated only by self-interest”

• Is rationality tautological? (Sen)

  • one can comply with this definition of rationality and still be a “fool” in a social and moral sense

  • In fact, the standard definition of economic rationality only requires self-consistency

• Is one preference ranking sufficient? (Sen)

  • the idea of “commitment”: the possibility that one chooses an action that leads to lower utility than another, because it relates to some outcome that is seen as important for other reasons

  • It requires a ranking of rankings

• Is all action about the outcome? (Hirschman)

  • some activities may not be instrumental

  • What motivates actors to engage in such activities? • Two modes of action • “Attaining”: rewards derive from attaining goals • “Striving”: rewards flow from the very process of engaging in the activity

• What about preferences? Can we not discuss them too? ()

  • Must we limit ourselves to analyzing how to satisfy given preferences in the optimal way


Economic rationality

• Under risk

  • I know the set of possible states of the world that can

    happen

  • I know the effect each state of the world will have on my

    payoff

  • I know the effect they have on the decision I make

  • I know the probability with which each state of the world

    happens

• Under weak uncertainty

  • I know the possible states of the world that can occur, and the effect each will have on my payoff

  • But I don’t know their probability

• Under strong uncertainty

  • We don’t even know all the relevant states of the world nor their probability


Herbert Simon’s bounded rationality

  • According to Simon the theory is composed by:

    • 1. Individual have a utility function, able to assign a cardinal value to measure the preference about any particular future scenario.

    • 2. Individuals have a well-defined set of alternative they can choose.

    • 3. Individual assign consistent joint probability distribution to all future sets of events.

    • 4. Individual maximize their utility given the joint probability of alternative choices or strategies.

  • We do not consider the influence of every single aspect of the world on each decision

  • We do not consider the full set of scenarios

  • A large part of our effort is devoted to collecting information, rather than calculating the optimal choice

• Two contemporary interpretations

• Kahneman & Tversky’s heuristics and biases

  • the way of making decisions described above makes us biased

  • “Biases… as systematic, predictable error of judgment.”

  • Heuristic

• Gigerenzer’s fast and frugal heuristics

  • it is good that we make decisions in that way, because it allows us to make good enough decisions whilst saving cognitive effort

  • It is true that we use heuristics instead of doing all the calculations required by the risk model

  • we must look at whether our heuristics match the complexity of the environment

• Rationality


• Risk, weak uncertainty, strong uncertainty


• Bounded rationality


  • Focus the dicusionn on certainties, rankings. how rationality can evade you because there is a lot of guessing the future which is something that is inherently hard to do, even for experts. Copmare and constrating timescales, and future certainty. Further in the future it can be difficult to plan for.